Using a PPF to Illustrate the Benefits of Specialization and Trade

Production possibilities frontiers can be used to illustrate the benefits of specialization and trade. One of the ways a society can become more prosperous is to increase the degree to which it specializes its production in the goods or services it produces relatively well and trades for the other goods and services it needs and wants.

To illustrate this, consider a simple economy with two countries, the United States and China. Consider two products, bicycles and airplanes.

Assume the United States has resources and technology that yield the following production possibilities frontier:If all U.S. resources are devoted to the production of bicycles, it can produce a maximum of 4 million bicycles per year. This is represented in the graph above by point S. Alternatively, if all U.S. resources are devoted to the production of airplanes, it can produce a maximum of 40,000 airplanes per year. This is represented in the graph by point U. If resources are evenly split between the production of bicycles and airplanes, the U.S. could produce 2 million bicycles and 20,000 airplanes at point T. By shifting the allocation of resources between the two industries, the U.S. could produce at any point on or inside its PPF.

Assume China has resources and technology that yield the following production possibilities frontier:If all Chinese resources are devoted to the production of bicycles, it can produce a maximum of 6 million bicycles per year. This is represented in the graph above by point J. Alternatively, if all Chinese resources are devoted to the production of airplanes, it can produce a maximum of 30,000 airplanes per year. This is represented in the graph by point L. If resources are evenly split between the production of bicycles and airplanes, China could produce 3 million bicycles and 15,000 airplanes at point K. By shifting the allocation of resources between the two industries, China could produce at any point on or inside its PPF.

In the absence of trade, each country is forced to consume some combination of products on or inside its production possibilities frontier (PPF). Specialization and trade can improve the standard of living in both countries by allowing each country to consume a combination of products outside its production possibilities frontier. To see this, put the PPFs for the two countries on the same graph as illustrated below:Suppose that in the absence of trade, China produces at point K and the U.S. produces at point T. China produces and consumes 3 million bicycles and 15,000 airplanes. The U.S. produces and consumes 2 million bicycles and 20,000 airplanes.

Now consider the option of complete specialization in both countries. Suppose the U.S. completely specializes in the production of airplanes and produces at point U. This represents the U.S. producing 40,000 airplanes and zero bicycles. Suppose China completely specializes in the production of bicycles and produces at point J. This represents China producing 6 million bicycles and zero airplanes. If the U.S. then exports 20,000 airplanes to China in exchange for 3 million bicycles, both countries can then consume 3 million bicycles and 20,000 airplanes. This is represented in the graph above by point C.

The U.S. produces 40,000 airplanes, but exports 20,000 of them to China. It ends up with 20,000 airplanes. The U.S. produces no bicycles, but imports 3 million of them from China. With specialization and trade, the U.S. consumes 20,000 airplanes and 3 million bicycles.

China produces 6 million bicycles, but exports 3 million of them to the United States. It ends up with 3 million bicycles. China produces no airplanes, but imports 20,000 of them from the United States. With specialization and trade, China consumes 3 million bicycles and 20,000 airplanes.

Both countries are better off than in the absence of trade. Each country is able to consume at a point outside its production possibilities frontier (PPF).

In the absence of trade, China produced and consumed at point K. It had 3 million bicycles and 15,000 airplanes. With specialization and trade, China produces at point J, but consumes at point C. It has 3 million bicycles and 20,000 airplanes. China consumes the same number of bicycles and 5,000 additional airplanes.

In the absence of trade, the United States produced and consumed at point T. It had 2 million bicycles and 20,000 airplanes. With specialization and trade, the U.S. produces at point U, but consumes at point C. It has 3 million bicycles and 20,000 airplanes. The United States consumes an additional 1 million bicycles and the same number of airplanes.

Thus, production possibilities curves can be used to illustrate the benefits of specialization and trade.

Using a PPF to Illustrate the Unemployment

A production possibilities frontier can be used to illustrate how the unemployment or misallocation of resources causes a society to produce fewer goods and services than possible. The diagram above illustrates the production possibilities for the U.S. economy. All products can be divided into two categories. Military products (e.g., guns) are measured on the vertical axis. Civilian products (e.g., butter) are measured on the horizontal axis.

If all U.S. economic resources are fully and efficiently employed in the production of military products, the output of the U.S. economy occurs at point A. If all U.S. economic resources are fully and efficiently employed in the production of civilian products, the output of the U.S. economy occurs at point E. Points B, C, and D (and all other points on the production possibilities frontier) represent possible combinations of military and civilian products that could be produced in the United States if its resources are fully and efficiently employed. Points on the production possibilities frontier are efficient because it is not possible to produce any more output of one product (e.g., guns) with the existing resources unless less output of another product (e.g., butter) is produced.

Points J, K, L, M, and N (and all points a similar distance from the PPF) represent U.S. output when there is relatively low unemployment or relatively low inefficiency. All points inside the PPF are inefficient because it is possible to produce more of one product without sacrificing the output of other products (by employing some of the unemployed resources or using them more productively).

Points S, T, U, V, and W (and all points a similar distance from the PPF) represent U.S. output when there is relatively high unemployment or relatively high inefficiency. Increases in unemployment or inefficiency move the production point further from the PPF (toward the origin) representing less output of goods and services.

Production point Z is not possible with existing resources and technology. (But if additional resources are acquired or technology increases productivity, it may be possible to move the entire PPF in that direction.)

If a societal goal is to satisfy as many needs and wants for material possessions as possible, then a society should strive to produce at a production point on (or close to) the PPF.

Simple Economic Models - Topics for Further Study

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TOPICS FOR FURTHER STUDY

1. How would the circular flow diagram change if it also included government? What other flows could be added to make it more realistic?

2. Could a production possibilities curve be concave to the origin? Would the opportunity costs be increasing, decreasing, or constant?

3. Draw a production possibilities frontier for the example on page 54.

4. Draw a production possibilities frontier for the example on page 55.


6 hours x 20 pages of economics per hour = 120 pages of economics
6 hours x 50 pages of history per hour = 300 pages of history
4 hours x 20 pages of economics per hour = 80 pages of economics
4 hours x 50 pages of history per hour = 200 pages of history
6 hours x 20 pages of economics per hour = 120 pages of economics
6 hours x 50 pages of history per hour = 300 pages of history
4 hours x 20 pages of economics per hour = 80 pages of economics
4 hours x 50 pages of history per hour = 200 pages of history
5 hours x 50 pages of history per hour = 250 pages of history
5 hours x 30 pages of economics per hour = 150 pages of economics

Using a PPF to Illustrate the Benefits of Specialization and Trade

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A PPF Change that only Shifts One Intercept

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An Example of a Change in a PPF that only Shifts One Intercept

Suppose the vertical axis measures the quantity of agricultural products (i.e., food) produced by a society, while the horizontal axis measures the quantity of industrial products (i.e., machines) produced. Suppose there is a technological innovation that affects the production of agricultural products but does not affect the production of industrial products. An example of this might be genetic engineering that provides farmers with seeds which produce more output. With the same number of seeds, the same amount of farmland, the same amount of agricultural machinery and the same number of farmers, farmers are now able to produce more food products than they could before the technological innovation.

This technological change would shift the maximum amount of agricultural output that could be produced to a higher point on the vertical axis. Since the technological change did not affect the production of industrial products, the maximum amount of industrial output that could be produced would remain unchanged. Consequently, the new PPF after the technological change would have the same horizontal intercept, but a new, higher vertical intercept. Note that the new PPF has a steeper slope than the previous one. This tells us that the opportunity cost of industrial products has increased, while the opportunity cost of agricultural products has decreased.

Technological Innovation

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A Decrease in Resources

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An Increase in Resources

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A PPF with Increasing Opportunity Costs

A PPF with Increasing Opportunity Costs: Alternative Uses of Farmland in the United States

Consider an extreme use of farmland in the United States. Pretend all U.S. farmland is used to grow oranges. Orange trees are planted in the tropical areas, such as Florida and California. In areas less suited to growing oranges, green houses are built to create a tropical environment in which to grow oranges. There is a maximum quantity of oranges that can be produced with the finite amount of farmland and other resources in the United States. This point is illustrated by point A in the graph below. Now suppose the United States considers using some of the farmland to grow wheat instead of oranges. It makes sense to stop growing oranges and begin growing wheat on the farmland that is not well suited for growing oranges but is well suited for growing wheat (perhaps Kansas or Nebraska). In order to gain a billion bushels of wheat, the U.S. must sacrifice a relatively small amount of orange production (2 million tons). It is a relatively small amount of oranges because the land was not well suited for orange production anyway.


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Figure 3-5. A production possibilities frontier (PPF) for U.S. farmland.
Curved PPFs illustrate increasing opportunity costs.

If the U.S. continues to switch farmland out of orange production and into wheat production, then the quantity of oranges produced will go down and the quantity of wheat produced will increase. For each additional ton of wheat produced, however, the sacrifice (in terms of reduced orange production) increases. Land that was a little bit better at growing oranges (such as Oklahoma) will be used to grow wheat. So in order to gain an additional thousand tons of wheat, the U.S. must sacrifice a relatively larger amount of orange production.

Suppose this process continues until the entire country is planted in wheat (point E). This implies bulldozing orange groves in Florida and California to build greenhouses to grow wheat. To obtain those last billion bushels of wheat (moving from point D to point E), the U.S. must sacrifice a relatively large amount of orange production (10 million tons).

In this example, the opportunity cost of producing additional wheat increases as wheat production increases. The amount of orange production that must be foregone in order to produce additional wheat increases as wheat production increases. Thus, this is an example of increasing opportunity costs. Increasing opportunity costs occur when the quantity of one product that must be foregone to obtain a unit of another product increases as more is produced.
Graphically, increasing opportunity costs are illustrated by a production possibilities frontier that is convex to the origin. The slope of the PPF, which represents the opportunity costs, increases as the production point moves down the curve.

A PPF Change that only Shifts One Intercept

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Technological Innovation

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A Decrease in Resources

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An Increase in Resources

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Things that Shift Production Possibility Frontiers - Farmland example

Things that Shift Production Possibility Frontiers

A PPF can change its shape or positioning if the society gains or loses resources or if there is a change in technology.


An Example of a Change in a PPF that Shifts the Entire Curve

A production possibilities frontier (PPF) illustrates the possible production points for an economy with a given set of resources and technology. If the economy’s resources or technology change, then the production possibilities frontier will change, too. If there is a change in the number of hours devoted to study in the example above, then the PPF will change. For example, if you have six hours of time (instead of five), then the maximum amount of economics you could read is 120 pages (if you devote all six hours to reading economics and spend no time reading history). The maximum quantity of history you could read is 300 pages (if you devote all six hours to reading history and spend no time reading economics). Since one hour can be spent reading 20 pages of economics or 50 pages of history, the opportunity costs of reading economics and history are still constant (20 pages of economics = 50 pages of history). Thus, the PPF is a straight line with the same constant slope. Similarly, if there are only 4 hours of time, then the maximum amount of economics you could read is 80 pages (if you devote all four hours to reading economics and spend no time reading history). The maximum quantity of history you could read is 200 pages (if you devote all four hours to reading history and spend no time reading economics). The graph below illustrates how a change in resources can change the production possibilities frontier for an economy.

PPF for Cowboys - with Constant Opportunity Costs

In this example, we are considering two options for the work done on a ranch in an afternoon. Each cowboy has the ability to store 100 bales of hay in the barn if he devotes the entire afternoon to that activity. Alternatively, each cowboy could build 20 yards of fences if he spent the whole afternoon doing that. Other combinations are also possible. For example, if half of the afternoon is spent storing hay and the other half spent building fences, each cowboy could store 50 bales of hay and build 10 yards of fences. The opportunity costs in this example are constant. Since an afternoon can be spent either storing 100 bales of hay or building 20 yards of fences, the opportunity cost of an afternoon on the ranch is: Storing 100 bales of hay = building 20 yards of fences.

The graph above illustrates how the farm's production possibilities frontier (PPF) shifts further from the origin when the farm's resources increase from one cowboy to two cowboys. The slope of the PPF does not change because the technology (the productive ability of each cowboy) has not changed.

The primary economic lesson to be learned from this example is that an increase in economic resources (labor, capital, or natural resources) increases a society's ability to produce goods and services. If a society wants to increase its quantity of material possessions, one way to achieve this is by acquiring additional resources. This might include a conscious decision to invest more in education, technological research, and physical capital (such as factories and highways) or a change in health care (so workers stay productive longer) or immigration policy.